In my weekly update at GigaOm Pro (subscription required), I get into this key complication raised by FERC’s issuance of Order No. 745 last week. If you missed the story, here’s a recap — FERC has decided that demand response, which turns down power use at end user sites like factories, office buildings and residential neighborhoods, should be paid a price that puts it on an equal footing with power generators in energy markets.

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That’s kindof like Christmas morning for demand response operators — but they can’t open their presents just yet. The Regional Transmission Operators (RTOs) and Independent System Operators (ISOs) tasked with creating these new markets have until July 2011 to file compliance statements that set tariffs and thresholds for the new rule. A full-bore plan for how to measure the cost-effectiveness of demand response resources in both the day-ahead and real-time energy markets — the markets that FERC has targeted in its ruling — isn’t due until September 21, 2012.

That gives regulators, grid operators and industry participants plenty of time to hash out one of the key conflicts inherent in this issue: the question of what constitutes cost-effective demand response. That question, in turn, is largely tied up in the issue of whether demand response providers should have to subtract the retail value of the electricity they avoid buying when they turn down power — the view of many power plant operators — or whether they should be able to take that reduction as a profit alongside the payment they get for their negawatts.

I get into those arguments in past GigaOm Pro reports (subscription required), and have covered them in past stories tracking the progress of this issue at FERC. In brief, power plant operators and energy company organizations have argued that letting demand response operators claim a full energy market price for the negawatts they deliver could distort the market and make the grid less efficient. Constellation Energy (s CEG) — an energy company that both generates power and delivers demand response via its acquisition of CPower last year — has argued that view in filings to FERC, in fact.

But most demand response providers say that giving their power-down technologies an equal value as generated power will open up new markets and new revenues for their technologies. Audrey Zibelman, CEO of virtual power plant software startup Viridity Energy, estimated that the ruling could lead to a doubling or tripling of the value of most demand response assets, mainly by widening the window of hours per year where they can compete against power plants in energy markets.

That’s good for existing demand response customers, and it also helps land new ones, said Gregg Dixon, vice president of marketing for big demand response provider EnerNOC (s ENOC). Right now, most of EnerNOC’s portfolio of about 5,100 MW of customer load is involved in so-called capacity markets, set up specifically for long-range planning for year-ahead power needs, Dixon explained. (By way of example, FERC’s recent order affirming that EnerNOC was following market rules in a pricing dispute with PJM pertained to those capacity markets).

Still, about 1,000 MW of EnerNOC’s customer base are signed up to deliver demand response in price-responsive energy markets like those FERC’s order are meant to address, he said. And putting FERC’s ruling into effect there could yield as much as a fivefold increase in the number of hours per year available for those customers to make money, he said.

More demand response isn’t just good for demand response providers, according to Zibelman, it could lower peak power prices for everyone. That’s because more competitors in the energy markets should drive down prices as the markets unfold on a day-to-day basis.

But that same market mechanisms lies at the heart of the power generators’ objection to FERC’s new rule. The concern is that demand response, if bid into markets at subsidized rates, could lower prices below those that big power plants need to realize a proper return on their investment. That could lead to some peak power plants shutting down, and new ones not getting built, which would pretty much cancel out the benefits of more demand response.

I’m curious to see how FERC’s process unfolds to take account of these concerns. As part of their market-planning process, FERC is requiring ISOs and RTOs to come up with “net benefits test” that can show when demand response is cost-effective. That’s a far too complicated subject to get into in this article, but if you’re interested, check out the section of FERC’s order (PDF) that deals with it. I don’t envy the grid operators that have to come up with these plans, but they should make for interesting reading.

Maybe I’m missing something, but this all seems pretty straightforward. You pay the same price for peak demand reductions that you would pay for peak supply (principle FERC is enshrining). From a grid operator perspective, a MWh reduced is the same a MWh produced. I understand that the politics are complicated, but from an academic perspective this is Econ 101, matching supply (peak supply & DR resources) and demand (capacity needed to keep the grid functional). Sure, some DR players will get a higher price than the lowest marginal price that would incentivize them to reduce demand, but that’s capitalism. Push comes to shove Walmart can lower their prices and accept a lower profit margin if market demand is reduced or competition becomes more intense, but as long as they are cheaper than anyone else, they win in the market. Until you get to a point where there is a “DR monopoly”, there are no market distortions.

Only big question I see is the specific methodology used to calculate the demand reduction, not the price issue. You don’t want to flood the market with a lot of phantom DR that isn’t going to hold up in the light of day.

My understanding is the generators are making the separate point that since there are “real” costs with supply they can’t compete against DR, which will affect the market. But that’s like the Horse & Buggy Lobby saying cars should have an extra tax because they are so different from the “normal” way of transporting someone from point A to point B.

Good point, you two. I’m not an energy economist, but I believe the point the generators are making in their arguments is that, at a certain point, the effect of bidding demand response assets into the energy markets can lead to a less efficient process for allocating incentives to both demand and supply-side resources. That is, while getting rid of peaker plants is a good thing, you can’t get rid of TOO many of them… but just how the ISOs and RTOs should achieve that balance is a topic of much debate. I’ll keep reporting on this as the plans roll out in mid-summer â€” perhaps there will be more clarity at that point.

“That could lead to some peak power plants shutting down, and new ones not getting built, which would pretty much cancel out the benefits of more demand response.”

Why isn’t reducing the operation and building of peak power plants the goal of increased demand response? If demand resources reduce total costs then it shouldn’t matter what happens to the generation industry (from a policy perspective)…